GAO United States General Accounting Office

Testimony

For Release on Delivery Zxpected at 1O:OO a.m. Wednesday August 2, 1989

LEASE REFINANCING

Observations on GSA's Proposed Master Leasing and Army's Lease Refinancing Programs

Statement of Jeffrey C. Steinhoff Director, Financial Management Systems Issues Accounting and Financial Management Division

Before the Committee on Government Operations House of Representatives

rm/ ‘3Qu, GAO/T-AFMD-89-4

Mr. Chairman and Members of the Committee:

We are pleased to be here today to discuss our initial

assessment of the Master Installment Purchase System (MIPS)

program proposed by the General Services Administration (GSA) and

the related Army program of lease refinancings currently

underway. As you requested, we assessed whether separating the

purchasing and financing of equipment under a master lease, as

called for by the MIPS and Army programs, could significantly

reduce lease finance costs. This testimony is our interim report

on the structure, scope, and objectives of the proposed MIPS and

Army lease refinancing programs and the potential for these

programs to reduce federal equipment leasing costs.

Both programs have the potential for reducing lease finance

costs by obtaining financing from private investors based on

borrowing rates available directly to the government rather than

the rates available to equipment vendor/lessors. Finance costs

can be high because, under current federal lease practices, the

borrowing rates available to equipment vendors/lessors reflect

their credit rating, rather than the federal government's. As a

result, vendor/lessor borrowing rates are often higher than those

available directly to the government.

A key reason why agencies lease equipment rather than

purchase it outright is because budget constraints preclude them

from obtaining the budget authority for outright purchases in a

single fiscal year. Leases with purchase options allow agencies

to acquire needed equipment while spreading out the budgetary

impact of the acquisition cost over several fiscal years. The

major additional cost to the government of spreading out the

budgetary impact of equipment purchases through leasing is the

difference between the rates tied to Treasury securities and

those available from private sector borrowers. The MIPS and Army

lease refinancing programs, which involve purchasing the

equipment from the vendor/lessor and obtaining financing in the

private sector financial markets, based on the government's

credit rating, reduce total leasing costs by reducing the lease

finance cost component.

My remarks today will cover five areas: information on

equipment leasing, GAO's prior work in this area, the GSA and

Army programs, and the proposed automatic data processing

equipment pilot program included in the Committee's July 20

discussion draft of the Paperwork Reduction Act reauthorization.

EQUIPMENT LEASING REQUIREMENTS

The Federal Acquisition Regulation (FAR) contains guidance

on the acquisition of equipment by lease or purchase. The FAR

envisions two primary means for agencies to acquire needed

equipment: (1) the one-time, outright purchase of equipment and

(2) the lease (rental) of equipment.

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Equipment should be purchased when there is an established,

long-term need for it and the technology involved is not changing

so rapidly as to render it obsolete in the short-term. The

underlying premise is that outright purchases result in the

lowest cost because financing would be based on interest rates on

comparable Treasury securities.

On the other hand, equipment should be leased when the

government has a short-term need for the equipment and/or the

equipment is subject to rapid state-of-the-art changes and

advances in technology. In this case, leasing would normally

cost less than purchasing the equipment. However, since the

federal budgetary environment and Gramm-Rudman-Hollings targets

look at cost on a cash basis, an agency is not always in a

position to make the most cost-effective or economical decision

on whether to purchase or lease.

The FAR provides that if a lease is warranted, a lease with

a purchase option is generally preferable. Such leases allow

agencies to acquire equipment and to spread out the budgetary

impact over a number of fiscal years. These leases, however, are

more costly than outright purchases because they are financed at

the lessors' generally higher borrowing rates and because lessors

charge additional fees to compensate them in case agencies

exercise clauses intended to protect the government's interest,

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such as the termination for convenience, right of offset, and

risk of loss.

PRIOR GAO REVIEW

ON LEASE FINANCING

In a 1985 report,1 GAO addressed the issue of leases with

high finance costs in relation to computer leasing practices.

We pointed out that agencies generally lease ADP equipment from

the manufacturer using the following three types of leases:

-- Rental lease. The lessor retains title to the equipment

throughout the system life, and the leases are annual

leases with options for annual renewals.

-- Lease with option to purchase. The lessor retains title

to the equipment until agencies exercise lease purchase

options. Under these leases, agencies earn rental or

purchase option credits which are used to reduce the

purchase price of the equipment. These are also annual

leases, and agencies are under no obligation to continue

the lease beyond each annual lease period.

1Effective Management of Computer Leasing Needed to Reduce Government Costs (GAO/IMTEC-85-3, March 21, 1985).

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-- Lease-to-ownership plans. Title transfers to the

agencies after payment of a predetermined number of lease

payments. These are annual leases with annual options to

renew. Agencies are not obligated to renew the leases.

GSA's proposed MIPS and the Army's current lease refinancing

programs are both responsive to our 1985 report. Both

initiatives use the principles of a sale/leaseback transaction

discussed in our 1985 report to separate the purchase of the

equipment from the acquisition financing to support the

equipment purchase.

PROPOSED MIPS PROGRAM

COULD REDUCE FUTURE

EQUIPMENT LEASE COSTS

Conceptually, GSA's proposed MIPS program can reduce the

government's leasing costs. However, there are still some issues

to be resolved before the program can be implemented.

The MIPS program involves only new leases for information

technology (IT) equipment. Under the, MIPS proposal, an agency

would solicit equipment purchase and lease prices from

vendor/lessors. If the agency has sufficient budgetary

authority, it would generally purchase the equipment. If not, it

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could agree to lease the equipment through the proposed MIPS

program.

The MIPS proposal would separate equipment procurement from

lease financing. Specifically, GSA would retain a private

contractor to develop and implement the MIPS program under which

GSA and the contractor would periodically pool equipment that

agencies intend to acquire under a master lease. The contractor

would purchase the equipment and raise the funds to support the

purchases by selling financial interests in the master lease to

private investors. GSA and the contractor would jointly develop

a standard master lease that GSA would use when entering into a

multiyear agreement with the contractor under the IT Fund's

multiyear contracting authority. GSA would lease the equipment

back to the agencies under an interagency agreement. Agencies

would make lease payments to GSA's IT Fund from which one lease

payment would be made to the contractor who would repay the

investors. At the end of the multiyear lease term, GSA would own

the leased equipment.

Under the MIPS program, potential savings result from

arranging lower lease financing than is available from the

equipment vendor/lessor. The proposed MIPS program facilitates

the use of private financial markets to finance lease

acquisitions by the creation of pools of leased equipment with

aggregate dollar values large enough to attract investors and to

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allow offerings through established private securities markets.

In addition, MIPS program pooling of equipment helps spread the

financial risks investors may have on any one item of equipment

that the government may lease because the government will be less

likely not to renew an entire pool than it would be to fail to

renew a single lease, thus making them more attractive

investments.

MIPS-type master financing lease programs have been

successfully used by states and large cities to reduce their

leasing costs. Florida, Michigan, New York, and West Virginia

have used master lease programs to fund the acquisition of

capital assets.

The Office of Management and Budget (OMB) has objected to

the MIPS program for two reasons. First, OMB views such programs

as installment purchase contracts which are more costly than

outright purchases and enable agencies to purchase equipment

without fully disclosing the total acquisition costs. Second,

OMB maintains that such programs may violate the Anti-

Deficiency Act since agencies, in effect, would be entering into

multiyear installment purchase contracts that commit the

government to pay for the entire cost of the equipment

acquisition while obligating only annual costs. Although all of

the details of GSA's MIPS program proposal have not been

finalized, we believe that GSA can develop a MIPS program

consistent with the Anti-Deficiency Act.

PROPOSED PILOT TO TEST MIPS-TYPE PROGRAM FEASIBILITY

Section 203 of the Committee's discussion draft directs GSA

to establish a pilot program designed to reduce the financing

costs of leasing ADP equipment. We have two general comments to

offer the Committee in connection with its consideration of this

section.

First, section 203 mandates that GSA establish a MIPS-type

program. As you may know, GSA in the past has considered

various proposals to reduce ADP lease financing costs, most

recently its MIPS proposal, but has not yet implemented a

proposal. Section 203 would require GSA to implement such a

program on a pilot basis.

Second, the language of section 203 of the discussion draft

is not entirely consistent with the MIPS concept as we understand

it. For example, the discussion draft appears to contemplate

that GSA will only aggregate agency leases instead of either

aggregating agency leases or new equipment under a master lease.

Also, the discussion draft suggests that GSA would be performing

several of the functions that under the MIPS proposal, as we

understand it, would be performed by the third-party contractor.

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To improve the technical precision of the Committee's

proposal, we would be happy to work with the Committee to revise

section 203 to more closely reflect our understanding of a MIPS-

type program.

ARMY'S PROGRAM OF LEASE

REFINANCINGS COULD

APPRECIABLY REDUCE CURRENT

EQUIPMENT LEASE COSTS

The Army program of refinancing existing leases could reduce

the costs of such leases. Its program covers all types of

equipment currently leased by the Army, including ADP and

telecommunications equipment, vehicles, and construction

equipment. The program entails

-- identifying equipment leases with purchase options and

high finance costs:

-- establishing pools of high finance cost leases and

exercising the Army's equipment purchase options:

-- financing the equipment purchases by selling financial

interests in the pools of leases to private investors;

and

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-- leasing the purchased equipment back to the Army, at

lower costs, under a standard master lease agreement.

The Army's program uses a master lease concept similar to

the MIPS program, but it has several fundamental differences.

Specifically, the Army's program:

-- Will not result in a multiyear contract. The master

lease may be renewed on an annual basis at the option of

the Army.

-- Is not an installment purchase program for new equipment,

but instead is a program to exercise purchase options

contained in existing equipment leases and lease the

equipment back.

-- Makes existing leases more economical by reducing their

finance costs.

Army does not have the requisite data for estimating how

much couid be saved by implementing its lease refinancing

program. Army and Department of Defense (DOD) financial

management systems for leases do not contain the detailed

information needed to identify equipment leases with high finance

costs. Army is in the process of identifying these leases. The

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time-consuming effort is still underway and must be completed

before Army can pool these leases for refinancing and estimate

cost savings.

While information is not available to estimate potential

lease cost savings, lease financing concepts such as MIPS and the

Army program have the potential for appreciable dollar savings.

OBSERVATIONS

The outright purchase of equipment, financed through

issuance of Treasury debt, is the lowest cost method of financing

equipment acquisitions. If, however, outright equipment

purchases are not feasible, and a lease is selected as the means

to finance equipment acquisitions, a MIPS-type program has the

potential to reduce equipment leasing costs. If properly

structured and implemented, a MIPS approach appears to be a

reasonable compromise to fit equipment acquisitions within

budgetary authority, outlay, and deficit reduction targets and

to reduce the high financing costs associated with the current

financing leases held by the government. A pilot program as

envisioned by section 203 of the discussion draft provides a

mechanism to test the feasibility and cost-saving potential of a

MIPS-type program. The Army program of lease refinancings

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appears to be a reasonable remedial method to reduce the

financing costs associated with existing lease purchase

contracts.

The next phase of our review for the Committee will focus on

assessing the feasibility and potential benefits of implementing

MIPS or an Army-type lease refinancing concept DOD-wide.

Mr. Chairman, this concludes my prepared statement. I will

be happy to answer any questions you or members of the Committee

have at this time.

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